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Money, Commodities, Balls, and How Much Deflation is Enough?
Money: How Much Deflation is Enough?
Once again, we see that the cure for all of the world’s ills is quantitative easing. Since there is apparently no downside to QE, it is a shame that we didn’t figure this out earlier. The S&P could have been at 200,000, rather than just 2,000, if only governments and central banks had figured out a century ago that running large deficits, combined with having a central bank purchase large amounts of that debt in the open market, was the key to rallying assets without limit.
That paragraph is obviously tongue-in-cheek, but on a narrow time-scale it really looks like it is true. The Fed pursued quantitative easing with no yet-obvious downside, and stocks blasted off to heights rarely seen before; the Bank of Japan’s QE has added 94% to the Nikkei in the slightly more than two years since Abe was elected; and today’s announcement by the ECB of a full-scale QE program boosted share values by 1-2% from Europe to the United States.
The ECB’s program, to be sure, was above expectations. Rather than the €50bln per month that had been mooted over the last couple of days with little currency-market reaction, the ECB pledged €60bln. And they promised to continue until September 2016, making the total value of QE around €1.1 trillion. (That’s about $1.3 trillion at today’s exchange rate, but of course if it works then it will be much less than $1.3 trillion at the September 2016 exchange rate). To be sure, a central bank always has the prerogative to change its mind, but on the risks of a sudden change in policy please see “Swiss National Bank”. It really is remarkable that Draghi was able to drag the Bundesbank kicking and screaming into this policy choice, and it is certain to end the threat of primary deflation in Europe just as it did in the U.S. and in Japan. It will likely also have similar effects on growth, which is to say “next to nothing.” But in Europe, deflation risks stemming from slow money growth had been a risk (see chart, source Bloomberg).
Interestingly, y/y money growth had already been accelerating as of late last year – the ECB releases M2 with a very long lag – but this puts the dot on the exclamation point. The ECB has said “enough!” There will be no core deflation in Europe.
Commodities: How Much Deflation is Enough?
Last week, in “Commodities Re-Thunk” and “Little Update on Commodities Re-Thunk”, I presented the results of using a generalization of the Erb & Harvey approach to forecast expected long-term real returns for commodities. It occurred to me that, since I have previously played with long-term real equity returns, and we have the real yield on 10-year TIPS as well, that it would be interesting to see if using these figures might produce a useful strategy for switching between assets (which doesn’t change the fact that I am a long-term investor; this is still based on long-term values. We merely want to put our assets in whatever offers the best long term value at the moment so as to maximize our expected long-term return).
The answer is yes. Now, I did a more-elegant version of what I am about to show, but the chart below shows the results of switching 100% of your assets between stocks, commodities, and TIPS based on which asset class had the highest expected real yield at a given month-end. Each line is an asset class, except for the blue line which shows the strategy result.
The labels at the top show the asset class that dominated for a long period of time. In 2005 there were a couple of quick crossovers that had little impact, but by and large there were three main periods: from 1999-2005, commodities offered excellent expected real returns; from mid-2005 through early-2008 the strategy would have been primarily in TIPS, and subsequent to that the strategy would have been primarily in equities. Fascinating to me is that the overall strategy does so well even though it would have been invested in equities throughout the crash in 2008. The crash in commodities was worse.
Now what is really interesting is that there is a vertical line at the far right-hand side of the chart. That is because at the end of December, the expected real return to commodities finally exceeded that of equities for the first time in a very long time. For this “selling out” strategy, that means you should be entirely out of stocks and TIPS and entirely in commodities.
As I said, that is the coarse version of this approach. My more-elegant version optimized the portfolio to have a constant expected risk in real terms. It was much less risky as a result (10.5% annualized monthly standard deviation compared to 15.5% for the strategy shown above), had lower turnover, but still sported returns over this period of 9.5% compounded compared to 11.2% for the strategy above. I am not, in other words, suggesting that investors put 100% of their assets in commodities. But this method (along with lots of other signals) is now suggesting that it is time to put more into commodities.
Balls: How Much Deflation is Enough?
Being a football fan, I can’t keep from weighing in on one mystery about deflate-gate (incidentally, why do we need to put ‘gate’ on the end of every scandal? It wasn’t Water-gate, it was the Watergate Hotel that proved Nixon’s undoing. “Gate” is not a modifier). Really, this part isn’t such a mystery but I have seen much commentary on this point: “How did the balls get deflated during the game since they were approved before the game?”
The answer is really simple in the real world: the official picked up one of the balls, said “fine”, and put them back in the bag. He has a million things to do before the championship game and in years of refereeing he has probably never found even one ball out of spec. This sort of error happens everywhere there are low reject rates, and it’s why good quality control is very difficult. (Now, if you fired the ref every time a bad ball got through, you damn betcha those balls would be measured with NASA-like precision – which is perhaps a bad metaphor, since similar issues contributed to the Challenger disaster). The real mystery to me is: if the Patriots truly think they are the better team, why would they cheat, even a little? As with the CHF/EUR cross that we discussed yesterday, the downside is far worse than the gain on the upside.
Or, is it? The NFL will have a chance to establish the cost of recidivism in cheating. Maybe the Patriots were simply betting that the downside “tail” to their risky behavior was fairly short. If the NFL wants to put a stop to nickel-and-dime cheats, it can do that by dropping the hammer here.
Enter the Draghi
While we wait for our Employment Report tomorrow, there is plenty of excitement overseas.
The dollar continued to strengthen today, with the dollar index reaching the highest level since the middle of last year (see chart, source Bloomberg).
As with the rest of the dollar’s strengthening move, it was really not any of our own doing. The dollar is simply, and I suspect very temporarily, the best house in a bad neighborhood right now. In the UK, the Scots are about to vote for independence, or not, but it will be a close vote regardless. In Japan, the Yen is weakening again as the Bank of Japan continues to ease and Kuroda continues to jawbone against his currency.
In Europe this morning, the ECB surprised many observers by cutting its benchmark rate to the low, low rate of just 5 basis points (0.05%), and lowered the deposit rate to -0.2%…meaning that if a bank wants to leave money sitting at the ECB, it is forced to pay the ECB to hold it. A negative deposit rate is akin to the Fed setting interest on excess reserves at a negative figure, something that makes great sense if the point of quantitative easing is to get money into the economy. In the Fed’s case, it turns out that the real point was to de-lever the banks forcibly, so it didn’t care that the reserves were sitting inert, but in the ECB’s case they would really like to see inflation higher (core inflation for the whole Eurozone is under 1%) so it is important that any increase in the balance sheet of the central bank is reflected in actual currency in circulation.
Right now, the negative deposit rate isn’t so important since the ECB holds negligible deposits. But the negative deposit rate was step one; step two is to gin up the quantitative easing again. ECB President Draghi had promised several months ago to do so with ‘targeted LTRO’, and today he delivered by saying that the ECB has decided to begin TLTRO in October. The ECB will “purchase a broad portfolio of simple and transparent securities” even though some observers have noted that there aren’t a lot of asset-backed securities in the market to buy (but trust Wall Street on this: if there is a buyer of a few hundred billion Euros’ worth of such securities, those securities will be issued. Wall Street isn’t good at everything, but they’re darn good at finding ways to satisfy a motivated, huge buyer. (See “subprime MBS”).
This is significant, as I said it was when Draghi first mentioned this back in June. It is significant if they follow through, and at least at this point it appears they mean to do so. Now, Europe still needs to fight against the dampening effect on money velocity that lower interest rates are having, but at least they recognize the need to get M2 money growth above the 2.7% y/y rate it is at presently (which is, itself, above the 1.9% rate of the year ended April). Money growth in Europe is currently the lowest in the world, and – surprise! – deflation is the biggest threat in Europe. Go figure.
How does this affect inflation in the US?
Changes in the global money supply contributes to a global inflation process that underpins inflation rates around the world. The best way to think about the fluctuations in exchange rates, with respect to inflation, is that they allocate global inflation between countries (or, alternatively, you can think of inflation as being “global” plus “idiosyncratic”, where a country’s idiosyncratic inflationary or disinflationary policies affect the domestic inflation rate and the exchange rate with other countries). So, the ECB’s aggressive easing (when it happens) will have two main effects. First, it will tend to push up average inflation globally compared to what it would otherwise have been. Second, it will tend to weaken the Euro and strengthen the dollar so that inflation in Europe should rise relative to US inflation – all else being equal, which of course it is not.
With respect to this latter effect, I need to take pains to point out that it is a small effect, or rather than the relative movements in the currency need to be a lot bigger to be worth worrying about. A stronger dollar, in short, is not going to put much pressure on US inflation to be lower. The chart below (source: Enduring Investments) shows a proxy we use for core commodities inflation, ex-medical, against the broad trade-weighted dollar lagged 9 months.
You can see that core commodities respond broadly to the dollar’s strength or weakness. A 5% rise (decline) in the dollar causes, nine months later, a 1% decline (rise) in core commodities inflation, ex-medical care commodities. Core ex-medical care commodities represents about 18% of the consumption basket, and the dollar’s effect outside of that part of the basket is indeterminate at best, so we can say that a 5% rise in the dollar causes inflation to decline about 0.18%.
In short, don’t waste a lot of time worrying that the 4% rise in the dollar this year will lead to deflation any time soon. Against that 18% of the consumption basket, we have 57% of the basket (core services) inflating at 2.6%, and over half of that consists of primary and owners’ equivalent rents, which are rising at 3.3% and 2.7% respectively and have a lot of upward momentum. Unless the dollar shoots dramatically higher, it should not affect overall prices very much.
They Came to Play
I am generally reluctant to call anything a “game changer,” because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB’s historic action this morning. It probably does not “change the game” per se, but it is very significant.
Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:
“The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi’s election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.”
All of that changed, in one fell swoop, today. The ECB’s actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body’s decision to implement a negative deposit rate for bank reserves held at the ECB. This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is to actually penalize banks for holding excess reserves.
There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn’t change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn’t increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up “expensive” reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.
If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB’s deposit facility is only about €29bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).
But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400bln in “targeted” LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years.[1] Even more important, the central bank suspended the sterilization of LTRO. “Sterilization” is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB’s case there was evidently some concern that doing QE without sterilization was not permitted under the institution’s charter.
Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.
If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region’s money growth, and before long a turn higher in the region’s inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher – not that it needed any help, as it is already swinging higher.
The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps today, but have a long way to go before they are back to normal levels – see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps today).
Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not – and when the piper’s tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I’d rather be long breakevens.
[1] This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome “call” of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.
As They Do, Not As They Say
Over the past week or two we have seen and heard from the Fed (in the minutes released on Wednesday), the ECB (after their April 3rd meeting), the BOJ (after their April 7th meeting), and the Bank of England (today). Having heard from the “big four,” I think it’s very interesting to compare what they seem to be indicating they will do to what they probably ought to do. (I am actually going to neglect the BOE, since their situation is quite complex at the moment and probably too much for a reasonable-length article).
In the US, the latest surprise – for some people – was the dovish tenor of the FOMC minutes when they were released yesterday. I shake my head in wonder at anyone who has managed to convince themselves that Chairman Yellen is a closet hawk even after years of evidence to the contrary (not least being the fact that she was nominated at all – not since Volcker has any Fed chief with remotely hawkish credentials been nominated to the Chairman’s position). After the FOMC meeting itself, a few weeks ago, TIPS had been clobbered and some (although not me) attributed that to the hawkish tone of the statement and the fact that Yellen had mentioned offhand that a lengthy period of low rates after QE has ended might be something like six months. The Fed is not hawkish at this point in its history; this is not to say that it does not have hawkish members but on the whole it is a dovish institution and I maintain that the Fed will likely tighten too late, and too little. For now, the Fed seems to be trying to make clear that they are concerned about low inflation and not likely to step on the brakes any more than they have.
What ought the Fed to be doing right now? The Fed ought to be tightening. Though growth is not robust, “robust” growth cannot be the standard demanded before starting a tightening of monetary policy, especially when there are tremendous excess reserves. The monetary policy car has no traction with such huge reserves, and the Fed needs to start trying to get control so that when it is time to steer, it can do so. Moreover, with disinflation fears waxing – incredibly – at the FOMC, inflation is in fact heading higher. Median inflation should approach or exceed 3% this year, despite the Fed’s belief that it will be well below 2% for a very long time. In a few months, the fear of disinflation and deflation will seem quaint.
No increase in policy rates is going to be coming any time soon. The Fed will continue to tighten very slowly, by winding down QE and then possibly starting to mop up some of the trillions in extra liquidity. That’s a sine qua non to rates going up, unless the Fed decides to establish a floor with the interest rate on excess reserves and to ship big boxes of money to Wall Street. But the interesting part will be when the Fed starts to mop up that liquidity either by outright bond sales (unlikely) or by some sort of massive reverse repo operation. It will get interesting because this classic tightening maneuver won’t be met with rising short rates – making it clear even to non-Fed-watchers that the Fed has no control over short rates at the moment. Again, I seriously doubt that the Fed will move with alacrity towards a tighter policy, and as it is they are at least a couple of years behind. But even if they do continue to tighten it will take years, not months, for the system to approach a normal state of liquidity.
The ECB talks like it is ready to ease further. ECB President Draghi was perceived as extremely bullish at his post-meeting presser last week, and recently there has been more chatter about negative deposit rates or other ways to increase the money supply.
And they need to do it. Disinflation, and possibly even deflation, actually probably is the threat in Europe, because the ECB has allowed money growth to slow back to the too-slow range that characterized the post-credit-crisis period (see chart, source ECB).
This obvious failure to keep money growth up is one reason for the strength of the Euro since 2012 – while the Fed talks about tightening, but does so in a way that only a dove could love, the ECB talks about easing, but does so in a way that can only appeal to hawks. Currency traders can smell it – European monetary policy may be as poorly managed as US monetary policy is, but holders of a currency prefer when the central bank is printing 2% more every year, rather than 6-8% as in the US. (Which would you prefer, a 2% dilution of your equity ownership, or an 8% dilution?)
The problem for the ECB is that their legal structures have been set up so that, at least officially, they don’t have the same tools for QE that other central banks have. Theoretically, they are prohibited from purchasing government bonds without sterilizing the intervention since that would mean effectively financing member governments. What ought the ECB to do? Well, I suppose it ought to follow its charter, but in a perfect world it is the ECB, and not the BOE or Fed, which would be doing QE. I suppose it will not surprise any reader to discover that I am a cynic, and I suspect that the ECB will at some point conclude that ceasing to sterilize the OMT bond portfolio is somehow allowed, even though practically speaking that would be the same as buying new government bonds without sterilization. We have already found out that in a pinch, the Federal Reserve is willing to be moderately “flexible” when it comes to its legal mandates. It would not surprise me a bit to see the ECB take a similar step. I suspect this will not happen in the next few months, since core European inflation for the year ended February has risen to 1.0% after being as low at 0.7% at year-end, but if that figure doesn’t continue to rise – and there’s no reason I can see that it should – then the ECB may test its flexibility later this year.
In Japan, the Bank of Japan has lifted core inflation to 0.8%, and it will continue to rise. Money supply growth is over 4% y/y, but only just barely. I believe that in Japan, what they profess to want and what they actually will act to secure are one and the same: increased QE, in increasing amounts, until everyone realizes that they are serious, the Yen declines markedly, and deflation is finally banished from the nation.
So in the race for weaker currencies, I suspect Japan will eventually win, with the US placing second and Europe having – annoyingly for its central bank, who would like a weaker currency to spur growth – the strongest unit.
